How Google Apps Could Cost Microsoft Up to $18 Billion in Value

Gauging the Financial Impact of Free Microsoft Office

Responding to Google’s (GOOG) competitive threat on its cash cow, Microsoft (MSFT) decided to offer free web versions of its MS Office, either through an online version similar to Google Apps, or a pc based edition pre-installed in PCs through the OEMs. The free offering is likely to be ad supported. Microsoft has already offered ad supported versions of Microsoft Works in certain countries and is likely to build off that practice with the free online versions.

The ad based version could be supported by display and search ads and should have ready access to Bing throughout the applications.

Microsoft’s CEO contends that any free offering is aimed at steaming the piracy impact rather than defending its turf against Google. I disagree, while acknowledging this effort’s part in monetizing pirated users.

The particular business under threat is Microsoft Business Division (MBD), which accounted for 30% of revenues in fiscal 2008 and has extremely high margins. [See a previous analysis of Microsoft’s revenue breakout.] Even more specifically, Microsoft Office, which is housed in MBD, accounted for 75% of MBD revenues. Drilling down further, the consumer segment of Microsoft Office, which I believe is the most exposed to Google Apps and OpenOffice.org, accounted for 20% of MBD revenues. Therefore, only 6% of Microsoft’s total revenues is under threat from Google Apps. Small, but significant nonetheless, given the high cash flow contribution from those revenues. I believe that there are little costs, if any, associated with the consumer division, so close to 100% of every dollar in this segment drops to the bottom line. I believe that Microsoft will find a way to exclude business users from using the free version or make it prohibitively expensive.

So what’s the financial impact to Microsoft from a free ad supported model? As I noted above, the consumer segment is the unit that’s actually under threat and that unit generated $3.8 billion in revenues in fiscal year 2008, with profits slightly below that figure. Let’s assume revenue growth is flat in fiscal year 2009 that ended in June. So that’s the base level of profits under threat.

But wait. Under 50% of those revenues are derived from retail sales, lets say 45%, with the remainder derived from PC OEMs. Cannibalization is important in my analysis, which I believe will only apply to the retail version, for now, but will likely impact the OEM revenues as time passes. So we are now down to $1.7 billion of revenues that is actually under threat.

Let's assume that 25% of potential retail users (and revenues) initially switch to the free online version. That number will likely prove conservative as time passes and I think should approach 100% in a few years but let’s stay with it now. So we are down to $430 million is revenues that is potentially lost.

I argued that consumer revenues are 100% incremental margins since any costs of development, support, and marketing are likely applied to the business version. But let's assume some costs - 5% of revenues. Applying Microsoft’s 26% tax rate will lead to $300 million in lost profits or $0.03 per share. For reference, the Wall Street consensus estimate is $1.65 per share for fiscal year 2009.

Microsoft can then generate about a $2.50 CPM for display ads on the free version. Let’s ignore potential search revenues for now. Based on page view estimates, I believe that Microsoft can generate approximately $100 million in revenues annually from advertising. This partially offsets the $430 million loss revenue estimate bringing the total lost revenues from the free online version to $330 million.

Assuming a 75% contribution margin on the display business, accounting for ad networks, ad agencies, etc., the loss estimate reduces from $330 million to $245 million or closer to $0.02 per share.

So the initial impact is a loss of 2 cents per share.

If we assume 100% of the retail business converts to the free version, then the impact is a $1.5 billion loss to profits or $0.13 per share, after accounting for the advertising revenues. This equates to an 8% negative EPS impact. That 8% negative impact equates to about $2 per Microsoft share (15x multiple to the 13 cents). The share price didn’t budge on the news, which leads me to believe that investors haven’t walked through the analysis or that the negative implication was already priced into the shares.

Either way, Google has cost Microsoft about $2 per share in value or $18 billion at the most aggressive of assumptions, or $0.30 per share on my initial analysis of a loss of 2 cents a share. Score one for Google. Now it is Microsoft’s turn to B(r)ing it.

Comments

[Roger Knights:]

Me too. I believe Microsoft should respond (or at least seriously consider responding) to the threat of cheap or free cloud applications from Google, and a cheap OS, by offering a software metering option. IOW, users would get Office or Windows free, and then pay-as-they-go, based on their usage rate. If average users paid $1 per week for each of those products, or $8 per month on their credit card bill, they'd hardly notice it, and most wouldn't be tempted by "free."

There'd be some leakage from piracy, but those users couldn't be sure of getting their software updates from MS if MS detected possible funny business, so not too many would try it.

Jul 20 08:15 AM

[LA Tech:]

What a dumb ass dork this writer is. There is no mad rush from exchange users to Google Apps! There is a mad rush from Google make everyone believe that Google Apps is a Microsoft killer.

Unless and until Google amasses at least 10M PAID USERS for GoogleApps (currently less than 100K users PAY for GoogleApps) there is no threat to MSFT revenues, period.

And according to Google's latest 10Q report, GoogleApps is nowhere close to being 1% of Google Revenues, no matter what Google Enterprise claims.

Jul 20 10:20 AM

[Josh B Thom...:]

The analysis forgot to quantify the cost to GOOG if users switch to MSFT's on-line version of office. Google wanted this market and MSFT is taking it back according to your projections. MSFT has won. MSFT has successfully refortified their position in office applications.

MSFT's strategy of offering free on-line versions is to prepare consumers to the concepts of Azure. That's the actual, larger goal. GOOG is trying to 'win' a market that is clearly the past. GOOG is behind the times by a generation of software development. Articles like the above reassure GOOG this is not he case.

Jul 20 10:56 AM

[Wilhelm Reuch:]

I think the main purpose of Google Apps always has been to erode prices in this market (i.e. attack MS profits). They dont need the most adavanced online office or even any large market share - they need just enough mindshare to start the market expecting lower (or even free) prices. The same goes for ChromeOS.

More interesting in the longer run is that as younger generations now start to penetrate businesses I think the document-oriented paradigm may become unstuck. And if this happens - everything is up for grabs. It is this (sooner or later) coming market that stuff like Google Wave looks like it is targetting.

Jul 20 04:16 PM

[Media Tech ...:]

Reading is fundamental! The point was that Google's free apps has forced Microsoft's hand towards offering a free option that will cannibalizing the paid version.


On Jul 20 10:20 AM LA Tech wrote:

> What a dumb ass dork this writer is. There is no mad rush from exchange
> users to Google Apps! There is a mad rush from Google make everyone
> believe that Google Apps is a Microsoft killer.
>
> Unless and until Google amasses at least 10M PAID USERS for GoogleApps
> (currently less than 100K users PAY for GoogleApps) there is no threat
> to MSFT revenues, period.
>
> And according to Google's latest 10Q report, GoogleApps is nowhere
> close to being 1% of Google Revenues, no matter what Google Enterprise
> claims.

Jul 20 07:08 PM

[neutrino23:]

As does Wilhelm, I think MS has to worry about long term trends. In business you often have to use MS Office simply because everyone else does and you need it to participate. Once enough sub-groups start using something else (Google supplied or otherwise) there will be a tipping point such that business will accommodate multiple applications. That will be bad news for MS because once they lose that lock on the customer there will be a race to the bottom as different suppliers offer other applications in this "new" market.

Jul 20 08:32 PM

[ptaneja:]

I disagree with this analysis, in that you see Google Apps only as a rival to MS Office, and that too for the consumer segment. But the fact is, Google Apps is being advertised as an "MS Exchange Alternative" and "Microsoft SharePoint Alternative" since it brings functionality which is a LOT more than merely word processing and spreadsheets etc. It includes email, intranet workspaces, contact management, tasks, forums etc.

Even though Google doesnt not make incursions into Microsoft's turf in the big business domain, it will certainly do so for the SMb segment. Is is only to preempt this threat that Microsoft has launched Microsoft BPOS. For those interested in seeing a comparison between Google Apps and Microsoft BPOS, you can check out our recent chart - www.hyperoffice.com/go.../

Aug 26 01:34 PM